Investor portfolios should never be over-concentrated in one particular business or market sector. Investing in a broad range of businesses, through a variety of investment types — such as stocks, bonds, and Treasury bills, and in different industries helps to reduce investor risk and increase the return on their investments.
The Frankowski Firm has a strong track record of successfully handling securities arbitration cases based on overconcentration and failure to diversify. Some investors can wait longer for a return and are willing and able to accept varying levels of risk. Other investors may need an immediate return and are only willing to accept low or moderate risk.
Younger investors have more time to see results than older investors. A diversified portfolio should meet the expectations of the client and should take into consideration all of the risks and rewards that different product types and industry sectors may provide. Call The Frankowski Firm today at for a review of your portfolio. Your broker may be liable for over-concentrating your investments.
You can also complete our contact form to make an appointment. Risk is typically defined in portfolio theory as the standard deviation volatility of returns. Without an understanding of the return drivers underlying the strategies within a portfolio, however, this typical definition of risk is inadequate. Sound, rational return drivers are the key to any successful trading strategy. Risk can only be determined by an understanding and evaluation of these return drivers.
History is full of examples of seemingly low-risk investments characterized by consistent monthly returns with low volatility that suddenly became worthless because the investment was not based on a sound return driver. Therefore, risk is not determined by the volatility of returns. In fact, highly volatile trading strategies, if based on a sound, logical return driver, can be a "safe" contributor to a portfolio.
So, if the volatility of returns is not an acceptable definition of risk, what is a more appropriate definition? Drawdowns are the greatest impediment to high returns and the true measure of risk. It is far easier to lose money than it is to recover from those losses. A risk management plan must specifically address the destructive power of drawdowns.
Although volatility is not the true measure of risk since volatility does not adequately describe the underlying return driver , volatility still makes a significant contribution to the power of portfolio diversification. Portfolio performance measurement ratios, such as the Sharpe ratio , are typically expressed as t he relationship between risk-adjusted returns and portfolio risk. Therefore, when volatility decreases, the Sharpe ratio increases.
Once we have developed trading strategies based on sound return drivers, true portfolio diversification then involves the process of combining seemingly riskier individual positions into a safer diversified portfolio. How does the combination of positions improve the performance of a portfolio?
The answer is based on correlation , which is defined as "a statistical measure of how two securities move in relation to each other. How is this helpful? If returns are negatively correlated with each other, when one return stream is losing, another return stream is likely winning. Therefore, diversification reduces overall volatility. The volatility of the combined return stream is lower than the volatility of the individual return streams.
This diversification of return streams reduces portfolio volatility and since volatility is the denominator of the Sharpe ratio, as volatility decreases, the Sharpe Ratio increases. In fact, in the extreme case of perfect negative correlation, the Sharpe ratio goes to infinity! Therefore, the goal of true portfolio diversification is to combine strategies based on sound return drivers , which are non-correlated or even better negatively correlated.
Most investors are taught to build a portfolio based on asset classes usually limited to stocks, bonds and possibly real estate and to hold these positions for the long term. This approach is not only risky, but it is the equivalent of gambling. Portfolios must include strategies based on sound, logical return drivers.
True portfolio diversification provides the highest returns over time. A truly diversified portfolio will provide you with greater returns and less risk than a portfolio diversified only across conventional asset classes. In addition, the predictability of future performance can be increased by expanding the number of diverse return drivers employed in a portfolio.
Real Estate Investing.
However, some investors may actually become over-diversified. Here's how you can maintain an appropriate balance when constructing your portfolio. Most investment professionals agree that although diversification is no guarantee against loss, it is a prudent strategy to adopt towards long-range financial objectives. There are many studies demonstrating why diversification works—to put it simply by spreading your investments across various sectors or industries with low correlation to each other, you reduce price volatility.
This is because different industries and sectors don't move up and down at the same time or at the same rate. If you mix things up in your portfolio, you're less likely to experience major drops, because as some sectors encounter tough times, others may be thriving. This provides for a more consistent overall portfolio performance. That said, it's important to remember that no matter how diversified your portfolio is, your risk can never be eliminated.
You can reduce the risk associated with individual stocks what academics call unsystematic risk , but there are inherent market risks systematic risk that affect nearly every stock. No amount of diversification can prevent that. The generally accepted way to measure risk is by looking at volatility levels. That is, the more sharply a stock or portfolio moves within a period of time, the riskier that asset is. A statistical concept called standard deviation is used to measure volatility.
So, for the sake of this article, you can think of standard deviation as meaning "risk". According to modern portfolio theory , you'd come very close to achieving optimal diversity after adding about the twentieth stock to your portfolio. In Edwin J. Elton and Martin J. Gruber's book "Modern Portfolio Theory and Investment Analysis," they concluded that the average standard deviation risk of a single stock portfolio was However, they also found that with a portfolio of 20 stocks, the risk was reduced to less than 22 percent.
Therefore, the additional stocks from 20 to 1, only reduced the portfolio's risk by about 2. Many investors have the misguided view that risk is proportionately reduced with each additional stock in a portfolio, when in fact this couldn't be farther from the truth.
There is evidence that you can only reduce your risk to a certain point beyond which there is no further benefit from diversification. The study mentioned above did not suggest buying any 20 stocks equates with optimum diversification. Note from our original explanation of diversification that you need to buy stocks that are different from each other, whether by company size, industry, sector, country, etc.
Financially speaking, this means you are buying stocks that are uncorrelated—stocks that move in different directions during different times. We are only talking about diversification within your stock portfolio here.
A person's overall portfolio should also diversify among different asset classes—meaning allocating a certain percentage to bonds, commodities, real estate, alternative assets, and so on. Owning a mutual fund that invests in companies doesn't necessarily mean that you are at optimum diversification either.
Many mutual funds are sector-specific, so owning a telecom or healthcare mutual fund means you are diversified within that industry, but because of the high correlation between movements in stock prices within an industry, you are not diversified to the extent you could be by investing across various industries and sectors.
Balanced funds offer better risk protection than a sector-specific mutual fund because they own or more stocks across the entire market. Many mutual fund holders also suffer from being over-diversified. Some funds, especially the larger ones, have so many assets—given they have to invest a larger amount of cash—that they have to hold literally hundreds of stocks. In some cases, this makes it nearly impossible for the fund to outperform benchmarks and indexes—the whole reason you invested in the fund and are paying the fund manager a management fee.
Diversification is like ice cream. It's good, but only in moderation. Additionally, most of the benefits of diversification can be achieved with just 20 or 30 securities. Simple is often better, and simpler strategies often come with lower fees. Keep in mind that many U. Diversification remains an essential strategy for your clients, especially in times of heightened economic uncertainty like we are experiencing now. A well-diversified portfolio will be one of the best hedges against that uncertainty.
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Thank you for sharing! Your article was successfully shared with the contacts you provided. Source: iStock As a risk-reducing strategy, diversification has earned its place as one of the golden rules of investing. In times of uncertainty, especially, diversification offers three critical benefits to investors: 1. Risk Management With any investment, there is always a tradeoff between risk and return.
Your broker may be liable for over-concentrating your investments. You can also complete our contact form to make an appointment. Failure to Diversify. Attorneys Helping Investors File Claims When Stockbrokers Failure to Diversify Investments Professional counsel if your portfolio suffers due to failure to diversify investments Failure to Diversify Investments is a fundamental tenant of investment strategy.
Some examples of overconcentration are: Overconcentration in just one company. Industry overconcentration. Just as individual companies can lose money, industries have their ups and downs, too. Typical market fluctuations can cause an industry sector to suffer, as can foreign competition, U. Investing only in one sector of the economy is a mistake. Failure to diversify by product type. Pearce and his staff exceeded all of our expectations. We were able to reach a settlement that was of our complete satisfaction, all within a very smooth, professional and efficient process.
Pearce is now not only our lawyer but our family friend. We highly recommend him and his team! This law firm is the real deal. We were so lucky that they took our case as they have so much experience in securities and all the wrongdoing that happens in these investment companies where they mislead you and your money as in our case into schemes that are not what you think they are. Robert Pearce is one of the best lawyers around, a truly professional who will fight for you and will tell you as it is all the time.
We could not have gone thru this experience if it was not for all the advice, guidance and support he and all of his staff and associates brought to the game. For the best fighting chance, Robert Pearce is the lawyer you want in your corner. Attorney Robert Pearce was our lawyer in a case against a Brokerage Firm and I'm witness to his ability and intelligence to deal with lawyers from the most prominent law firm in New York which was the key to recovering much of our losses cheered by their negligence.
He never felt intimidated and his study of the case and perseverance prevailed at all times. No lawyer except Bob said I had a chance of winning. When UBS Lawyers laughingly offered me zero to settle the dispute, Bob became even more determined to prove everybody wrong. Bob was extremely prepared, and always a step ahead of the opposing attorneys throughout the arbitration. In the end, Bob and I had the last laugh when the arbitrators awarded me almost 6 million dollars.
Robert's team is excellent. They are very competitive in what they do and they are very responsible. Every meeting and phone call was made with dedication and desire to help our family every step of the way. Their professionalism, responsibility and empathy assured us that we were in good hands. Recommend to everyone. If you have suffered a loss to the value of your retirement accounts because your advisor recommended a strategy that over-concentrated your portfolio or there was a lack of diversification, you may have grounds for a claim to recover your losses.
Talk with Robert Pearce now Failure to Diversify or Overconcentration of Investments in Accounts Can Create Unnecessary Risk One of the most fundamental rules of investing is to diversify your portfolio. For example, one firm published the following in its marketing materials: No single asset class performs best in all economic environments.
With that in mind, here are three asset allocation rules you should know by heart. While it may be difficult to remember this deep into the incredible bull market we've been living through, stocks don't always go up. You can't predict when the market will fall, but one thing that's certain is that when it does fall, your bills won't wait for your portfolio to recover. When those bills come due during a bear market, if the only asset you have is stocks, then you'll be forced to sell more shares at a lower price to cover your costs.
That can be a recipe for running out of money far earlier than you otherwise might expect. That's the primary reason you need money in assets other than stocks, even though you'll probably get a lower return on that money over time. With a five-year buffer, you can ride through a lot of market turmoil and still wind up OK.
Of course, too much safety can also be a problem. If you hold all your assets in low-volatility, low-return assets, then you're putting yourself at risk of not being able to keep up with inflation over time. So balance the need for long-term growth against the need for near-term spending cash when it comes time to turn to your portfolio to help cover your costs.
Diversification is the closest thing to a free lunch available to ordinary investors. While it won't increase your expected rate of return, it will reduce the impact of a catastrophic failure in any one of your investments, better allowing the rest of your portfolio to hold up.
Taking that range and rounding it up to 20 also helps from a kitchen-table logic perspective. If that trend holds, in an equally weighted portfolio of 20 stocks, the complete loss of any one company would mean the loss of around half a year's expected return. While you'd still feel that loss, it wouldn't be completely devastating to your portfolio and would be something you should be able to recover from.
Contrast that with a concentrated portfolio, such as where most of your net worth is tied up in your employer's stock. If that single company runs into trouble, then you will find yourself in a world of financial hurt. That doesn't mean 25 times your total spending -- just the money that you need to come from that portfolio.
Most retired Americans get Social Security, which provides them an inflation-adjusted income stream. If that number seems totally out of reach given the time you have left before you retire, it's better to recognize it before you retire than after you do.
If you recognize it before you retire, you still have time to make adjustments, such as delaying Social Security to closer to age 70 to increase your monthly benefit. Work longer, and your portfolio won't need to last as long, which means you can spend more of it each year. Those three asset allocation rules provide a pretty decent foundation for a financial plan that can get you to and through retirement.
Indeed, they are so core and fundamental to your lifelong financial well-being that they're worth knowing by heart. Investors often rely on correlation averages across long historical periods when constructing portfolios, Page notes. But markets and economies both tend to move through distinct periods of calm and turbulence.
This can leave investors exposed to tail risk—unlikely but extreme events at either end of the probability distribution of potential market outcomes. Data analysis by T. Rowe Price. Correlations are a measurement of how one asset class, style or individual group are related to each other. A perfect positive correlation means that the correlation coefficient is exactly 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction.
A perfect negative correlation -1 means that two assets move in opposite directions, while a zero correlation implies no relationship at all. Falling interest rates and positive carry i. Dreyer notes that it is less clear whether those benefits will be as attractive in the future. With Federal Reserve policy rates now close to zero and the Fed showing little interest in taking rates negative, U.
Treasuries likely will be less effective as a hedge against tail risk in the future, which is unfortunate. In the s, for example, the correlation typically was positive. Treasuries, will continue to work as portfolio hedges against market volatility. Two other potential hedges historically have performed well in periods of equity and credit market volatility but also have their limitations in more normal periods. Gold prices often have fallen in the early stages of past market crises but typically have rebounded more quickly during recoveries.
However, the costs—such as premiums on options contracts—can be punitively high in more normal market periods. Liquidity risk—the possibility that investors may not be able to find buyers for assets they urgently need to sell—can be the primary culprit when diversification benefits disappear during periods of extreme market volatility. Page uses the analogy of a burning building: To get out of the building, investors need to find a buyer willing to take their place inside the building—not an easy task in the middle of a crisis.
Higher capital requirements have made broker-dealers less willing to hold relatively risky securities in inventory. Many investment consultants and other analysts argue that private equity and other assets that are not traded in public markets have diversification characteristics that potentially make them highly effective hedges against market volatility. But the diversification benefits of private assets are more apparent than real, Page argues.
Page says he does believe that diversification across both public and private assets can be useful when appropriate. As markets and economies continue to recover from the coronavirus pandemic, investors will face the question of when—and how—to increase portfolio exposure to equities and other relatively risky asset classes.
From a strategic perspective, Page argues, investors should remain diversified for the long run. From a tactical perspective, however, they may be able to seek opportunities during a downturn and in the early stages of a market recovery by leaning into risk assets. Although the market outlook depends heavily on the course of the pandemic and the strength of the global economic recovery, Page says he believes investors who have added to their positions during the downturn and in the initial stages of the market rebound could be rewarded this time as well.
However, the Fed can only do so much to improve the outlook for corporate credit, Husain says. While the U. Total Return Index, and non-U. The success rate represents the percent of times that stocks had positive returns. For illustrative purposes only; not indicative of any specific investment.
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Derivatives typically involve risks different from, and possibly greater than, the risks associated with investing directly in the assets on which the derivative is based. Certain derivatives can be highly volatile, lack liquidity, be difficult to value, involve counterparty risk, may be considered speculative and are not suitable for everyone.
Changes in the value of a derivative may not properly correlate with changes in the value of the underlying asset, reference rate, or index. Private assets are considered speculative therefore subject to a unique set of risks; they are not suitable for everyone. These risks include, but are not limited to, potential illiquidity and lack of a secondary market to trade securities, management risk, concentration and non-diversification risk, foreign investment risk, lack of transparency, leverage risk, and volatility.
Investing in private companies involves greater risk than investing in stocks of established publicly traded companies. Gold is subject to increased risks such as higher price volatility and geopolitical risks.